Via the excellent Damien Boey at Credit Suisse:
Bond and money market investors, as well as the Fed, have been keeping tabs on debt ceiling negotiations. Officially, the fear has been that if legislation were to not change, the US government would “run out of money” by September, causing shutdown and “default”.
The official narrative is of course quite misleading. The debt ceiling is a self-imposed constraint on the Treasury. Not only can it be lifted with the right political agreement – but even if it is not lifted, the Treasury can still spend without raising new debt. This is because the Treasury has access to back-door, “overdraft-like” spending facilities with the Fed. The Treasury has a reserve, or “general account” (TGA) with the Fed that it runs down whenever it spends. And when it does this, it creates several accounting entries in the system – deposits for the general public, held with the commercial banks, and excess reserves for the commercial banks (or exchange settlement account, ESA balances), held with the Fed. All other things being equal, the creation of excess reserves in the interbank system drops the Fed funds rate down to zero. But all other things are not equal. In the first place, the Treasury could issue bonds to the banks, to swap their excess reserves for longer duration, higher yielding securities. This called an open market, or sterilization operation. Secondly, the Fed could (and does) choose to offer interest on excess reserves to segment the Fed funds market, and give the Fed some control over a smaller segment of the market.
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